CHAPTER 6.

MACROECONOMIC POLICIES
❖ Macroeconomic policies affect the overall performance
of the economy.
▪ Two main macroeconomics policies are the financial/monetary and fiscal
policy.

▪ These policies will be used to achieve macroeconomics objectives, such

as full employment, price stability and satisfactory economic growth.

❖ Monetary and fiscal policies can each influence

aggregate demand.
▪ Thus, a change in one of these policies can lead to short-run fluctuations
in output and prices.

1
 Cont…

▪ Policymakers will want to anticipate this effect

and, perhaps, adjust the other policy in response.

▪ Central banks have to decide how to control the

money supply and interest rates (if they can), and
whether to fix the exchange rate or let it float.

▪ Governments have to decide how much to spend and

how to finance their spending through taxes,
borrowing, or printing money.

2
 Cont…
❖ Many factors influence aggregate demand besides monetary and
fiscal policy.

▪ In particular, desired spending by households and firms determines the

overall demand for goods and services.

▪ When desired spending changes, aggregate demand shifts.

▪ If policymakers do not respond, such shifts in aggregate demand

cause short-run fluctuations in output and employment.

▪ As a result, monetary and fiscal policymakers sometimes use the policy

levers at their disposal to try to offset these shifts in aggregate demand
and thereby stabilize the economy.

3
6.1. Monetary Policy
❖ Monetary/financial policy is the process by which the monetary
authority (Central Bank- Fed) of a country controls the supply of
money, often targeting a rate of interest to attain a set of
objectives oriented towards the growth and stability of the
economy.

▪ Monetary policy is the changes in interest rates and money supply

to expand or contract aggregate demand.
▪ In a recession, expansionary monetary policy-"easy money" involves
lowering interest rates and increasing the money supply.

▪ In an overheated expansion, contractionary monetary policy-"tight

money" raises interest rates and decreases the money supply.
4
6.1.1. Monetary policy tools
❖ The tools of monetary policy are those available to the central
bank to control the excess reserves of banks.
▪ They include open market operations, changes in required reserve
ratios and changes in the discount rate.

▪ It is normal to believe that control over the physical printing of bank

notes is the essence of monetary policy, but that is not entirely correct.

▪ Since the monetary multiplier shows that banks have the ability
to create most of the money, control over reserves which banks
can lend, is the real focus of monetary policy.

5
Reserve requirement:
❖ Banks are required to hold a certain percentage (cash reserve ratio, or
CRR) of their deposits in reserve in order to ensure that they always
have enough cash to meet withdrawal requests of their depositors.

▪ Not all depositors are likely to withdraw their money simultaneously.

▪ So the CRR is usually around 10%, which means banks are free to
lend the remaining 90%.

▪ By changing the CRR requirement for banks, the Central Bank can
control the amount of lending in the economy, and therefore the money
supply with reserve requirements, which are regulations on the minimum
amount of reserves that banks must hold against deposits.

6
 Cont…
▪ An increase in reserve requirements means that banks must hold more reserves
and, therefore, can loan out less of each dollar that is deposited; as a result, it raises
the reserve ratio, lowers the money multiplier, and decreases the money supply.

▪ Conversely, a decrease in reserve requirements lowers the reserve ratio, raises the
money multiplier, and increases the money supply.

❖ The central bank uses changes in reserve requirements only rarely because
frequent changes would disrupt the business of banking.

▪ When the Fed increases reserve requirements, for instance, some banks find
themselves short of reserves, even though they have seen no change in deposits.

▪ As a result, they have to curtail lending until they build their level of reserves to
the new required level.

7
Open market operations:
❖ Open market operations consist of buying and selling of
government securities/ bonds by the central bank.

▪ To increase the money supply, the central bank instructs its bond
traders to buy bonds in the nation’s bond markets.

▪ The cash the central bank pays for the bonds increase the number of
dollars in circulation.

❖ Some of these new dollars are held as currency, and some are
deposited in banks.

▪ Each new dollar held as currency increases the money supply by

exactly dollar 1.

8
 Cont…
▪ Each new dollar deposited in a bank increases the money supply to an
even greater extent because it increases reserves and, thereby, the amount
of money that the banking system can create.

❖ To reduce the money supply, the Central bank does just the opposite:

▪ It sells government bonds to the public in the nation’s bond markets.

▪ The public pays for these bonds with its holdings of currency and bank
deposits, directly reducing the amount of money in circulation.

▪ In addition, as people make withdrawals from banks, banks find

themselves with a smaller quantity of reserves.

▪ In response, banks reduce the amount of lending, and the process of

money creation reverses itself.

9
 Cont…
❖ Open-market operations are easy to conduct.

▪ In fact, the Central bank’s purchases and sales of government bonds in the
nation’s bond markets are similar to the transactions that any individual
might undertake for his own portfolio.

▪ Of course, when an individual buys or sells a bond, money changes hands,

but the amount of money in circulation remains the same.

▪ In addition, the Central bank can use open-market operations to change the
money supply by a small or large amount on any day without major
changes in laws or bank regulations.

❖ Therefore, open-market operations are the tool of monetary policy

that the Central bank uses most often.

10
Discount rate:
❖ It is the interest rate on the loans that the central bank makes
to banks.

▪ It is the cost of borrowing or, essentially, the price of money.

▪ The Central bank can alter the money supply by changing the
discount rate.

▪ This means by manipulating interest rates, the central bank can

make easier or harder to borrow money.

▪ A higher discount rate discourages banks from borrowing

reserves from the Central bank.

11
 Cont…
▪ Thus, an increase in the discount rate reduces the quantity of reserves in the
banking system, which in turn reduces the money supply.

▪ Conversely, a lower discount rate encourages bank borrowing from the

central bank, increases the quantity of reserves, and increases the money
supply.

❖ When money is cheap, there is more borrowing and more economic

activity.

▪ Lower rates also discourages saving and induce people to spend their
money rather than save it because they get so little return on their savings.

12
6.1.2. Monetary Policy and Aggregate Demand
6.1.2.1. Interest Rate Effect
❖ To understand how policy influences aggregate demand, we examine
the interest-rate effect in more detail.

▪ We consider a theory of how the interest rate is determined, called the

theory of liquidity preference.

❖ Keynes proposed the theory of liquidity preference to explain what

factors determine the economy’s interest rate.

▪ The theory is, in essence, just an application of supply and demand.

❖ According to Keynes, the interest rate adjusts to balance the supply

and demand for money.

13
 Cont…
▪ Economists distinguish two interest rates: the nominal interest
rate and the real interest rate.

▪ The nominal interest rate is the interest rate as usually reported,

and the real interest rate is the interest rate corrected for the effects
of inflation.

▪ In the analysis, we hold the expected rate of inflation constant.

▪ Thus, when the nominal interest rate rises or falls, the real interest
rate that people expect to earn rises or falls as well.

❖ The first piece of the theory of liquidity preference is the supply

of money.

14
 Cont…
▪ The Central Bank (Fed) alters the money supply primarily by changing
the quantity of reserves in the banking system through the purchase and
sale of government bonds in open market operations or by changing
reserve requirements (the amount of reserves banks must hold against
deposits) or the discount rate (the interest rate at which banks can borrow
reserves from the Central Bank).

❖ Assume that the Central Bank controls the money supply directly.

▪ In other words, the quantity of money supplied in the economy is fixed at

whatever level the Central Bank decides to set it.

▪ Because the quantity of money supplied is fixed by Central Bank policy, it

does not depend on other economic variables.

15
 Cont…
▪ In particular, it does not depend on the interest rate.

▪ We represent a fixed money supply with a vertical supply curve (Figure 6.1).

❖ The second piece of the theory of liquidity preference is the demand for
money.
▪ Recall that any asset’s liquidity refers to the ease with which that asset is converted
into the economy’s medium of exchange.

▪ Money is the most liquid asset available.

❖ Although many factors determine the quantity of money demanded,

the one emphasized by the theory of liquidity preference is the interest
rate.
▪ The reason is that the interest rate is the opportunity cost of holding money.

16
 Cont...
▪ That is, when you hold wealth as cash in your wallet, instead of as an
interest-bearing bond, you lose the interest you could have earned.

▪ An increase in the interest rate raises the cost of holding money and, as a
result, reduces the quantity of money demanded.

▪ A decrease in the interest rate reduces the cost of holding money and raises
the quantity demanded.

▪ Thus, the money-demand curve slopes downward, as shown in Figure 6.1.

❖ According to the theory of liquidity preference, the interest rate

adjusts to balance the supply and demand for money.

▪ At the equilibrium interest rate, the quantity of money demanded

exactly balances the quantity of money supplied.

17
 Cont…
▪ If the interest rate is at any other level, people will try to adjust their portfolios of
assets and, as a result, drive the interest rate toward the equilibrium.

❖ For example, suppose that the interest rate is above the equilibrium level, such
as r1 in Figure 6.1.

▪ In this case, the quantity of money that people want to hold, Md1, is less than the
quantity of money that the Central Bank has supplied.

▪ Those people who are holding the surplus of money will try to get rid of it by
buying interest-bearing bonds or by depositing it in an interest-bearing bank
account.

▪ Because bond issuers and banks prefer to pay lower interest rates, they respond to
this surplus of money by lowering the interest rates they offer.

18
 Cont…
▪ As the interest rate falls, people become more willing to hold money until, at the
equilibrium interest rate, people are happy to hold exactly the amount of money
the Central Bank has supplied.

❖ Conversely, at interest rates below the equilibrium level, such as r2 in Figure

6.1, the quantity of money that people want to hold, Md2, is greater than the
quantity of money that the Central Bank (Fed) has supplied.

▪ As a result, people try to increase their holdings of money by reducing their

holdings of bonds and other interest-bearing assets.

▪ As people cut back on their holdings of bonds, bond issuers find that they have to
offer higher interest rates to attract buyers.

▪ Thus, the interest rate rises and approaches the equilibrium level.

19
Figure 6.1: money market equilibrium

20
 Cont...
❖ The price level is one determinant of the quantity of money demanded.

▪ At higher prices, more money is exchanged every time a good or service is

sold.

▪ As a result, people will choose to hold a larger quantity of money.

❖ That is, a higher price level increases the quantity of money demanded for
any given interest rate.

▪ Thus, an increase in the price level from P1to P2 shifts the money-demand
curve to the right from MD1 to MD2, as shown in panel (a) of Figure 6.2.

❖ For a fixed money supply, the interest rate must rise to balance money
supply and money demand.

21
 Cont…
▪ The higher price level has increased the amount of money people want to hold and
has shifted the money demand curve to the right.

❖ Yet the quantity of money supplied is unchanged, so the interest rate must rise
from r1 to r2 to discourage the additional demand.

▪ At a higher interest rate, the cost of borrowing and the return to saving are
greater.

▪ Fewer households choose to borrow to buy a new house, and those who do buy
smaller houses, so the demand for residential investment falls.

▪ Fewer firms choose to borrow to build new factories and buy new equipment, so
business investment falls.

▪ Thus, when the price level rises from P1 to P2, increasing money demand from
MD1 to MD2 and raising the interest rate from r1 to r2, the quantity of goods and
services demanded falls from Y1 to Y2 (panel (b) of Figure 6.2).
22
 Cont…
❖ Hence, this analysis of the interest-rate effect can be summarized in three
steps:
(1) A higher price level raises money demand.

(2) Higher money demand leads to a higher interest rate.

(3) A higher interest rate reduces the quantity of goods and services demanded.

▪ Of course, in the reverse, a lower price level reduces money demand, which
leads to a lower interest rate, and this in turn increases the quantity of goods
and services demanded.

▪ The end result of this analysis is a negative relationship between the

price level and the quantity of goods and services demanded, which is
illustrated with a downward-sloping aggregate-demand curve.

23
Figure 6.2 change in price level and aggregate demand curve

24
6.1.2.2. Changes in the Money Supply
❖ Whenever the quantity of goods and services demanded
changes for a given price level, the aggregate-demand
curve shifts.

▪ One important variable that shifts the aggregate-demand

curve is monetary policy.

❖ To see how monetary policy affects the economy in the

short run, suppose that the Central Bank (Fed)
increases the money supply by buying government
bonds in open-market operations.

25
 Cont…
▪ An increase in the money supply shifts the money-supply curve to
the right from MS1 to MS2, as shown in panel (a) of Figure 6.3.

▪ Because the money-demand curve has not changed, the interest

rate falls from r1 to r2 to balance money supply and money
demand.

▪ That is, the interest rate must fall to induce people to hold the
additional money the Central Bank has created.

▪ The lower interest rate reduces the cost of borrowing and the
return to saving.

26
 Cont…
▪ Households buy more and larger houses, stimulating the demand
for residential investment.

▪ Firms spend more on new factories and new equipment,

stimulating business investment.

▪ As a result, the quantity of goods and services demanded at a

given price level, P, rises from Y1 to Y2, as shown in panel (b) of
Figure 6.3.

❖ The monetary injection raises the quantity of goods and

services demanded at every price level.

▪ Thus, the entire aggregate-demand curve shifts to the right.

27
Figure 6.3 change in money supply and aggregate demand curve

28
To sum up:
▪ When the Central Bank increases the money supply, it lowers the
interest rate and increases the quantity of goods and services demanded
for any given price level, shifting the aggregate-demand curve to the right.

▪ Conversely, when the Central Bank contracts the money supply, it raises
the interest rate and reduces the quantity of goods and services demanded
for any given price level, shifting the aggregate-demand curve to the left.

▪ Changes in monetary policy that aim to expand aggregate demand can

be described either as increasing the money supply or as lowering the
interest rate.

▪ Changes in monetary policy that aim to contract aggregate demand can

be described either as decreasing the money supply or as raising the
interest rate.
29
6.2. Fiscal Policy
❖ Fiscal policy is changes in the taxing and spending of the
government for purposes of expanding or contracting the
level of aggregate demand thereby achieving economic
objectives of price stability, full employment and economic
growth.

▪ In a recession, an expansionary fiscal policy involves

lowering taxes and increasing government spending.

▪ In an overheated expansion, a contractionary fiscal policy

requires higher taxes and reduced spending.

30
 Cont...

▪ When government spends more than the income

tax collected, it suffers a budget deficit whereas

▪ it will have a budget surplus if its revenue is

more than its expenditure.

31
6.2.1. Changes in Government Purchases
❖ When policymakers change the money supply or the level of taxes,
they shift the aggregate-demand curve by influencing the spending
decisions of firms or households.

▪ By contrast, when the government alters its own purchases of goods

and services, it shifts the aggregate-demand curve directly.

❖ Suppose the government purchase of goods has increased by Birr 20

billion.

▪ This order raises the demand for the output, which induces the
company to hire more workers and increase production.

32
 Cont…
▪ The increase in the demand for product means an increase in the total
quantity of goods and services demanded at each price level.

▪ As a result, the aggregate-demand curve shifts to the right but not

exactly by Birr 20 billion.

❖ There are two macroeconomic effects that make the size of the shift in
aggregate demand differ from the change in government purchases.

▪ The first-the multiplier effect-suggests that the shift in aggregate demand

could be larger than government purchase, Birr 20 billion.

▪ The second-the crowding-out effect-suggests that the shift in aggregate

demand could be smaller than Birr 20 billion.

33
The Multiplier Effect
❖ When the government buys Birr 20 billion of goods from a company, that
purchase has repercussions.

▪ The immediate impact of the higher demand from the government is to raise
employment and profits at company.

▪ Then, as the workers see higher earnings and the firm owners see higher profits,
they respond to this increase in income by rising their own spending on
consumer goods.

▪ As a result, the government purchase from company raises the demand for the
products of many other firms in the economy.

❖ Because each dollar spent by the government can raise the aggregate demand
for goods and services by more than a dollar, government purchases are said
to have a multiplier effect on aggregate demand.

34
 Cont…
▪ This multiplier effect continues even after this first round.

▪ When consumer spending rises, the firms that produce these

consumer goods hire more people and experience higher profits.

▪ Higher earnings and profits stimulate consumer spending once again,

and so on.

▪ Thus, there is positive feedback as higher demand leads to higher

income, which in turn leads to even higher demand.

❖ Once all these effects are added together, the total impact on the
quantity of goods and services demanded can be much larger than
the initial impulse from higher government spending.

35
 Cont…
▪ The increase in government purchases of Birr 20 billion
initially shifts the aggregate-demand curve to the right from
AD1 to AD2 by exactly Birr 20 billion.
▪ But when consumers respond by increasing their
spending, the aggregate-demand curve shifts still further
to AD3 (Figure 6.4).
❖ This multiplier effect arising from the response of
consumer spending can be strengthened by the response
of investment to higher levels of demand.

36
 Cont...

▪ For instance, the company might respond to the

higher demand for goods by deciding to buy more
equipment or build another plant.

▪ In this case, higher government demand spurs

higher demand for investment goods.

▪ This positive feedback from demand to investment

is sometimes called the investment accelerator.

37
Figure 6.4 Government purchase multiplier effect

38
 Cont…
❖ A formula for the size of the multiplier effect arises from
consumer spending.

❖ An important number in this formula is the marginal

propensity to consume (MPC)-the fraction of extra income that
a household consumes rather than saves.

▪ For example, suppose that the marginal propensity to consume is

3/4.

▪ This means that for every extra Birr that a household earns, the
household spends Birr 0.75 (3/4 of the Birr) and saves Birr 0.25.

39
 Cont…
❖ To gauge the impact on aggregate demand of a change in
government purchases, we follow the effects step-by-step.

▪ The process begins when the government spends Birr 20 billion,

which implies that national income (earnings and profits) also rises
by this amount.

▪ This increase in income in turn raises consumer spending by MPC

x Birr 20 billion, which in turn raises the income for the workers and
owners of the firms that produce the consumption goods.

▪ This second increase in income again raises consumer spending

by MPC(MPCxBirr 20 billion).

40
 Cont...
▪ Here, “. . .” represents an infinite number of similar terms.

▪ Thus, Multiplier=1+MPC+MPC2+MPC3+• • •

❖ This multiplier tells us the demand for goods and services that
each Birr of government purchases generates.

▪ To simplify this equation for the multiplier, recall that this

expression is an infinite geometric series.

▪ For X between -1 and +1, 1+X+X2+X3• ••=1/ (1-X). , X=MPC.

▪ Thus, Multiplier (dY/dG) =1/ (1-MPC).

41
 Cont…
▪ These feedback effects go on and on...

❖ To find the total impact on the demand for goods and

services, we add up all these effects:

▪ Change in government purchases…… Birr20 billion

▪ First change in consumption ………MPCxBirr20 billion

▪ Second change in consumption …MPC2xBirr20 billion

▪ Third change in consumption ……MPC3xBirr20 billion

▪ Total change in demand……(1+MPC+MPC2+MPC3+…) x

Birr 20 billion

42
 Cont…
❖ The size of the multiplier depends on the marginal
propensity to consume.

▪ Whereas an MPC of 3/4 leads to a multiplier of 4, an MPC

of 1/2 leads to a multiplier of only 2.

▪ Thus, a larger MPC means a larger multiplier.

▪ The multiplier arises because higher income induces

greater spending on consumption.

▪ The larger the MPC is, the greater is this induced effect on
consumption, and the larger is the multiplier.
43
The Crowding-Out Effect
❖ While an increase in government purchases stimulates the aggregate
demand for goods and services, it also causes the interest rate to rise,
and a higher interest rate reduces investment spending and chokes off
aggregate demand.

▪ The reduction in aggregate demand when a fiscal expansion raises the

interest rate is called the crowding-out effect.

▪ The increase in demand raises the incomes of the workers and owners of
this firm (and, because of the multiplier effect, of other firms as well).

▪ As incomes rise, households plan to buy more goods and services and
choose to hold more of their wealth in liquid form.

44
 Cont…
▪ That is, the increase in income caused by the fiscal expansion raises the
demand for money.

❖ Because the Fed has not changed the money supply, the vertical
supply curve remains the same.

▪ When the higher level of income shifts the money-demand curve to the
right from MD1 to MD2, the interest rate must rise from r1to r2 to keep
supply and demand in balance, as shown in panel (a) of Figure 6.5.

▪ The increase in the interest rate, in turn, reduces the quantity of goods
and services demanded.

▪ In particular, because borrowing is more expensive, the demand for

residential and business investment goods declines.

45
 Cont…
❖ That is, as the increase in government purchases increases the demand
for goods and services, it may also crowd out investment.

▪ This crowding-out effect partially offsets the impact of government

purchases on aggregate demand, as illustrated in panel (b) of Figure 6.5.

▪ The initial impact of the increase in government purchases is to shift the

aggregate-demand curve from AD1 to AD2, but once crowding out takes
place, the aggregate-demand curve drops back to AD3.

▪ To sum up: When the government increases its purchases by Birr 20

billion, the aggregate demand for goods and services could rise by more or
less than Birr 20 billion, depending on whether the multiplier effect or the
crowding-out effect is larger.

46
Figure 6.5 Crowding out effect

47
6.2.2. Changes in Taxes
❖ When the government cuts personal income taxes, for instance, it
increases households’ take-home pay.

▪ Households will save some of this additional income, but they will also
spend some of it on consumer goods.

▪ Because it increases consumer spending, the tax cut shifts the

aggregate-demand curve to the right.

▪ Similarly, a tax increase depresses consumer spending and shifts the

aggregate-demand curve to the left.

❖ The size of the shift in aggregate demand resulting from a tax

change is also affected by the multiplier and crowding-out effects.

48
 Cont…
▪ When the government cuts taxes and stimulates consumer spending,
earnings and profits rise, which further stimulates consumer spending.

❖ This is the multiplier effect.

▪ At the same time, higher income leads to higher money demand, which
tends to raise interest rates.

▪ Higher interest rates make borrowing more costly, which reduces

investment spending.

❖ This is the crowding-out effect.

▪ Depending on the size of the multiplier and crowding-out effects, the shift
in aggregate demand could be larger or smaller than the tax change that
causes it.

49
 Cont…
❖ In addition to the multiplier and crowding-out effects, there is
another important determinant of the size of the shift in
aggregate demand that results from a tax change: households’
perceptions about whether the tax change is permanent or
temporary.

▪ For example, suppose that the government announces a tax cut of

Birr 1,000 per household.

▪ In deciding how much of this Birr 1,000 to spend, households must

ask themselves how long this extra income will last.

50
 Cont…
▪ If households expect the tax cut to be permanent, they will view it as
adding substantially to their financial resources and, therefore, increase
their spending by a large amount.

▪ In this case, the tax cut will have a large impact on aggregate demand.

▪ By contrast, if households expect the tax change to be temporary, they

will view it as adding only slightly to their financial resources and,
therefore, will increase their spending by only a small amount.

▪ In this case, the tax cut will have a small impact on aggregate demand.

51
6.3. Stabilization Policy
❖ Fluctuations in the economy as a whole come from changes in
aggregate supply or aggregate demand.

▪ Economists call exogenous changes/shifts in these curves shocks to

the economy.

▪ These shocks disrupt economic well-being by pushing output and

employment away from their natural rates.
❑ One goal of the model of aggregate supply and aggregate demand is to
show how shocks cause economic fluctuations.

❑ Another goal of the model is to evaluate how macroeconomic policy

can respond to these shocks.

52
 Cont…

❖Economists use the term stabilization policy to

refer to policy actions aimed at reducing the
severity of short-run economic fluctuations.

▪ Because output and employment fluctuate around

their long-run natural rates, stabilization policy
dampens the business cycle by keeping output
and employment as close to their natural rates as
possible.
53
 Cont…
❖ Some economists, such as William McChesney Martin, view the
economy as inherently unstable.

▪ They argue that the economy experiences frequent shocks to

aggregate demand and aggregate supply.

▪ Unless policymakers use monetary and fiscal policy to stabilize the

economy, these shocks will lead to unnecessary and inefficient
fluctuations in output, unemployment, and inflation.

▪ According to the popular saying, macroeconomic policy should

“lean against the wind,’’ stimulating the economy when it is
depressed and slowing the economy when it is overheated.

54
 Cont…
❖ Other economists, such as Milton Friedman, view the economy
as naturally stable.

▪ They blame bad economic policies for the large and inefficient
fluctuations we have sometimes experienced.

▪ They argue that economic policy should not try to “fine-tune’’ the
economy.

▪ Instead, economic policymakers should admit their limited abilities

and be satisfied if they do no harm.

▪ This debate has persisted for decades, with numerous protagonists

advancing various arguments for their positions.

55
 Cont…
❖ The fundamental issue is how policymakers should use the
theory of short-run economic fluctuations.

▪ In this section we ask two questions that arise in this debate.

❑ First, should monetary and fiscal policy take an active role in trying to
stabilize the economy, or should policy remain passive?

❑ Second, should policymakers be free to use their discretion in

responding to changing economic conditions, or should they be
committed to following a fixed policy rule?

56
6.3.1. Active Policy versus Passive Policy
❖ The monetary and fiscal policy can affect the economy’s
aggregate demand for goods and services.

▪ These theoretical insights raise some important policy questions:

▪ Should policy makers use these instruments to control aggregate

demand and stabilize the economy?
▪ If so, when?

▪ If not, why not?

▪ Therefore, let’s consider some of the arguments on using active or

passive policy and examine how stabilization policy works and
what practical problems arise in its use.

57
6.3.1.1. Active Stabilization Policy
❖ When the government cuts spending, aggregate demand will fall.

▪ This will depress production and employment in the short run.

❖ If the Central Bank wants to prevent this adverse effect of the fiscal
policy, it can act to expand aggregate demand by increasing the money
supply.

▪ A monetary expansion would reduce interest rates, stimulate investment

spending, and expand aggregate demand.

▪ If monetary policy responds appropriately, the combined changes in

monetary and fiscal policy could leave the aggregate demand for goods
and services unaffected.

58
 Cont…
▪ This response of monetary policy to the change in fiscal policy is an
example of a more general phenomenon: the use of policy
instruments to stabilize aggregate demand and, as a result,
production and employment.

❖ Keynes emphasized the key role of aggregate demand in

explaining short-run economic fluctuations.

▪ Keynes claimed that the government should actively stimulate

aggregate demand when aggregate demand appeared insufficient to
maintain production at its full-employment level.

59
 Cont…
❖ Keynes (and his many followers) argued that aggregate demand
fluctuates because of largely irrational waves of pessimism and
optimism.

▪ When pessimism reigns, households reduce consumption spending, and

firms reduce investment spending.

▪ The result is reduced aggregate demand, lower production, and higher

unemployment.

▪ Conversely, when optimism reigns, households and firms increase

spending.

▪ The result is higher aggregate demand, higher production, and inflationary

pressure.

60
 Cont…
▪ Notice that these changes in attitude are, to some extent, self-
fulfilling.

❖ In principle, the government can adjust its monetary and fiscal

policy in response to these waves of optimism and pessimism
and, thereby, stabilize the economy.

▪ For example, when people are excessively pessimistic, the Fed can
expand the money supply to lower interest rates and expand
aggregate demand.

▪ When they are excessively optimistic, it can contract the money

supply to raise interest rates and dampen aggregate demand.

61
6.3.1.2. Passive Policy
❖ Some economists argue that the government should avoid active use of
monetary and fiscal policy to try to stabilize the economy.
▪ They claim that these policy instruments should be set to achieve long-run
goals, such as rapid economic growth and low inflation, and that the economy
should be left to deal with short-run fluctuations on its own.

❖ Although these economists may admit that monetary and fiscal policy
can stabilize the economy in theory, they doubt whether it can do so in
practice.
▪ The primary argument against active monetary and fiscal policy is that these
policies affect the economy with a substantial lag.

❖ Economists distinguish between two lags in the conduct of stabilization policy:

the inside lag and the outside lag.

62
 Cont…
❖ The inside lag is the time between a shock to the economy and the
policy action responding to that shock.
▪ This lag arises because it takes time for policymakers first to recognize that a
shock has occurred and then to put appropriate policies into effect.

❖ The inside lag, hence, is divided into recognition, decision, and action
lags.

▪ The recognition lag is the period that elapses between the time a
disturbance occurs and the time the policy makers recognize that action is
required.
▪ The lag might be somewhat shorter when the required policy is expansionary
and somewhat longer when restrictive policy is required.

63
 Cont…
▪ The decision lag is the delay between the recognition of the need
for action and the policy decision.

▪ Further, the action lag is the lag between the policy decision and its
implementation.

▪ The inside lag is a discrete lag-so many months-from recognition

to decision and implementation.

❖ The outside lag is the time between a policy action and its
influence on the economy.

▪ This lag arises because policies do not immediately influence

spending, income, and employment.

64
 Cont…
▪ The outside lag is generally a distributed lag: once the policy action has been
taken, its effects on the economy are spread over time.

▪ There may be a small immediate effect of a policy action, but other effects
occur later.

❖ Monetary policy has a much shorter inside lag than fiscal policy, because
a central bank can decide on and implement a policy change in less than a
day, but monetary policy has a substantial outside lag.
▪ But many firms make investment plans far in advance.

▪ Thus, most economists believe that it takes at least six months for changes in
monetary policy to have much effect on output and employment.

▪ Moreover, once these effects occur, they can last for several years.

65
 Cont…
❖ Critics of stabilization policy argue that because of this lag, the Fed
should not try to fine-tune the economy.

▪ They claim that the Fed often reacts too late to changing economic
conditions and, as a result, ends up being a cause of rather than a cure for
economic fluctuations.

▪ These critics advocate a passive monetary policy, such as slow and

steady growth in the money supply.

▪ Unlike the lag in monetary policy, the lag in fiscal policy is largely
attributable to the political process.

❖ A long inside lag is a central problem with using fiscal policy for
economic stabilization.

66
 Cont...
▪ This is especially true in the United States, where changes in spending
or taxes require the approval of the president and both houses of
Congress.

▪ The slow and cumbersome legislative process often leads to delays, which
make fiscal policy an imprecise tool for stabilizing the economy.

▪ Completing this process can take months and, in some cases, years.

▪ By the time the change in fiscal policy is passed and ready to implement,
the condition of the economy may well have changed.

▪ This inside lag is shorter in countries with parliamentary systems,

such as the United Kingdom, because there the party in power can
often enact policy changes more rapidly.

67
 Cont…
❖ These lags in monetary and fiscal policy are a problem in
part because economic forecasting is so imprecise.

▪ If forecasters could accurately predict the condition of the

economy a year in advance, then monetary and fiscal policy
makers could look ahead when making policy decisions.

▪ In practice, however, major recessions and depressions arrive

without much advance warning.

▪ The best policymakers can do at any time is to respond to

economic changes as they occur.
68
6.3.1.3. Automatic Stabilizers
❖ All economists-both advocates and critics of stabilization policy-agree
that the lags in implementation render policy less useful as a tool for
short-run stabilization.

▪ Thus, automatic stabilizers are designed to reduce the lags associated

with stabilization policy.

▪ Automatic stabilizers are policies that stimulate or depress the economy

when necessary without any deliberate policy change.

❖ The most important automatic stabilizer is the tax system.

▪ When the economy goes into a recession, the amount of taxes collected by
the government falls automatically because almost all taxes are closely tied
to economic activity.

69
 Cont…
▪ The personal income tax depends on households’ incomes, the payroll tax depends
on workers’ earnings, and the corporate income tax depends on firms’ profits.

▪ Because incomes, earnings, and profits all fall in a recession, the government’s tax
revenue falls as well.

▪ This automatic tax cut stimulates aggregate demand and, thereby, reduces the
magnitude of economic fluctuations.

❖ Government spending also acts as an automatic stabilizer.

▪ In particular, when the economy goes into a recession and workers are laid off;
more people apply for unemployment insurance benefits, welfare benefits, and
other forms of income support.

▪ This automatic increase in government spending stimulates aggregate demand at

exactly the time when aggregate demand is insufficient to maintain full
employment.
70
6.3.2. Policy by Rule versus Policy by Discretion
❖ A second topic of debate among economists is whether economic
policy should be conducted by rule or by discretion.

▪ Policy is conducted by rule if policymakers announce in advance how

policy will respond to various situations and commit themselves to
following through on this announcement.

▪ Policy is conducted by discretion if policymakers are free to size up

events as they occur and choose whatever policy seems appropriate at the
time.

▪ The debate over rules versus discretion is distinct from the debate over
passive versus active policy.

▪ Policy can be conducted by rule and yet be either passive or active.

71
 Cont…
▪ For example, a passive policy rule might specify steady growth in the
money supply of 3 percent per year.

▪ An active policy rule might specify that:

Money Growth =3% + (Unemployment Rate -6%)

▪ Under this rule, the money supply grows at 3 percent if the unemployment
rate is 6 percent, but for every percentage point by which the
unemployment rate exceeds 6 percent, money growth increases by an extra
percentage point.

▪ This rule tries to stabilize the economy by raising money growth when the
economy is in a recession.

❖ Why policy might be improved by a commitment to a policy rule?

72
Distrust of Policymakers and the Political Process
▪ Some economists believe that economic policy is too important to be left to the
discretion of policymakers.

▪ Although this view is more political than economic, evaluating it is central to how
we judge the role of economic policy.

❖ If politicians are incompetent or opportunistic, then we may not want to give

them the discretion to use the powerful tools of monetary and fiscal policy.

▪ Incompetence in economic policy arises for several reasons.

▪ Some economists view the political process as erratic, perhaps because it reflects
the shifting power of special interest groups.

▪ In addition, macroeconomics is complicated, and politicians often do not have

sufficient knowledge of it to make informed judgments.

73
 Cont…
▪ This ignorance allows charlatans to propose incorrect but superficially
appealing solutions to complex problems.

▪ The political process often cannot weed out the advice of charlatans from
that of competent economists.

❖ Opportunism in economic policy arises when the objectives of

policymakers conflict with the well-being of the public.

▪ Some economists fear that politicians use macroeconomic policy to further

their own electoral ends.

▪ If citizens vote on the basis of economic conditions prevailing at the time

of the election, then politicians have an incentive to pursue policies that
will make the economy look good during election years.

74
 Cont…
▪ A president might cause a recession soon after coming into office to lower inflation
and then stimulate the economy as the next election approaches to lower
unemployment; this would ensure that both inflation and unemployment are low
on Election Day.

▪ Manipulation of the economy for electoral gain, called the political business cycle,
has been the subject of extensive research by economists and political scientists.

❖ Distrust of the political process leads some economists to advocate placing

economic policy outside the realm of politics.

▪ Some have proposed constitutional amendments, such as a balanced-budget

amendment, that would tie the hands of legislators and insulate the economy from
both incompetence and opportunism.

75
The Time Inconsistency of Discretionary Policy
▪ If we assume that we can trust our policymakers, discretion at first glance appears
superior to a fixed policy rule.

▪ Discretionary policy is, by its nature, flexible.

❖ As long as policymakers are intelligent and benevolent, there might appear to

be little reason to deny them flexibility in responding to changing conditions.

▪ Yet a case for rules over discretion arises from the problem of time inconsistency
of policy.

▪ In some situations policymakers may want to announce in advance the policy they
will follow in order to influence the expectations of private decision makers.

❖ But later, after the private decision makers have acted on the basis of their
expectations, these policymakers may be tempted to renege on their
announcement.

76
 Cont…
▪ Understanding that policymakers may be inconsistent over time, private
decision makers are led to distrust policy announcements.

▪ In this situation, to make their announcements credible, policymakers

may want to make a commitment to a fixed policy rule.

▪ Time inconsistency is illustrated most simply in a political rather than an

economic example-specifically, public policy about negotiating with terrorists
over the release of hostages.

▪ The announced policy of many nations is that they will not negotiate over
hostages.

▪ Such an announcement is intended to deter terrorists: if there is nothing to be

gained from kidnapping hostages, rational terrorists won’t kidnap any.

77
 Cont…
▪ In other words, the purpose of the announcement is to influence the
expectations of terrorists and thereby their behavior.

❖ But, in fact, unless the policymakers are credibly committed to the

policy, the announcement has little effect.

▪ Terrorists know that once hostages are taken, policymakers face an

overwhelming temptation to make some concession to obtain the hostages’
release.

▪ The only way to deter rational terrorists is to take away the discretion
of policymakers and commit them to a rule of never negotiating.

▪ If policymakers were truly unable to make concessions, the incentive for

terrorists to take hostages would be largely eliminated.

78
 Cont...
❖ The same problem arises less dramatically in the conduct of monetary
policy.

▪ Consider the dilemma of a central bank that cares about both inflation
and unemployment.

▪ According to the Phillips curve, the trade off between inflation and
unemployment depends on expected inflation.

▪ The Central Bank would prefer everyone to expect low inflation so that it
will face a favorable trade off.

❖ To reduce expected inflation, the Central Bank might announce that

low inflation is the paramount goal of monetary policy.

▪ But an announcement of a policy of low inflation is by itself not credible.

79
 Cont…
▪ Once households and firms have formed their expectations of inflation and
set wages and prices accordingly, the Central Bank has an incentive to
renege on its announcement and implement expansionary monetary policy
to reduce unemployment.

❖ People understand the Central Bank’s incentive to renege and

therefore do not believe the announcement in the first place.

▪ Just as a president facing a hostage crisis is sorely tempted to negotiate

their release, a Central Bank with discretion is sorely tempted to inflate in
order to reduce unemployment.

▪ And just as terrorists discount announced policies of never negotiating,

households and firms discount announced policies of low inflation.

80
 Cont…
▪ The surprising outcome of this analysis is that policymakers
can sometimes better achieve their goals by having their
discretion taken away from them.

▪ In the case of rational terrorists, fewer hostages will be taken and

killed if policymakers are committed to following the seemingly
harsh rule of refusing to negotiate for hostages’ freedom.

▪ In the case of monetary policy, there will be lower inflation

without higher unemployment if the Central Bank is committed to
a policy of zero inflation.

81
 Cont...
❖ The time inconsistency of policy arises in many other contexts-some examples:

❑ To encourage investment, the government announces that it will not tax income
from capital.

▪ But after factories have been built, the government is tempted to renege on its
promise to raise more tax revenue from them.

❑ To encourage research, the government announces that it will give a temporary

monopoly to companies that discover new drugs.

▪ But after a drug has been discovered, the government is tempted to revoke the
patent or to regulate the price to make the drug more affordable.

❑ To encourage good behavior, a parent announces that he or she will punish a

child whenever the child breaks a rule.

82
 Cont…
▪ But after the child has misbehaved, the parent is tempted to forgive the
transgression, because punishment is unpleasant for the parent as well as for
the child.

❑ To encourage you to work hard, your professor announces that this

course will end with an exam.
▪ But after you have studied and learned all the material, the professor is
tempted to cancel the exam so that he or she won’t have to grade it.

❖ In each case, rational agents understand the incentive for the

policymaker to renege, and this expectation affects their behavior.

▪ And in each case, the solution is to take away the policymaker’s

discretion with a credible commitment to a fixed policy rule.

83
END OF CHAPTER SIX!

84